Essentially, forward contracts and futures contracts are agreements that allow traders, investors, and commodity producers to speculate on the future price of an asset. These contracts function as a commitment between two parties that allows trading of an instrument in the future (expiry date), at a price agreed upon when the contract was formed.
The basic financial instrument of a forward or future can be any type of asset, such as equity, commodities, currencies, interest payments or bonds.
However, unlike forward contracts, futures contracts are standardized contracts from a contractual point of view (as a legal agreement) and are traded on a specific location (futures contract exchange). Therefore, futures contracts are subject to several regulations, examples of which include contract size and daily interest rates. In many cases, the execution of a futures contract is guaranteed by a clearinghouse, allowing parties to trade with reduced peer-to-peer risk.
Although a primitive form of futures market was established in Europe in the 17th century, the Dōjima Rice Exchange (Japan) is considered to be the first futures exchange to be established. In early 18th century Japan, most payments were in rice, and therefore futures contracts began to be used as a way to hedge against the risks associated with rice price volatility.
With the advent of electronic trading systems, the popularity of futures contracts, along with their various use cases became widespread throughout the financial industry.
Future Contract Function
In the context of the financial industry, futures contracts specifically have the following functions:
Hedging and risk management: futures contracts can be used to eliminate a specific risk. For example, a farmer may sell futures contracts for their produce to ensure they get a certain price in the future, despite adverse events and market fluctuations. Or a Japanese investor who holds US bonds could purchase a JPYUSD futures contract for an amount equal to the quarterly coupon payment (interest rate) in JPY at a predetermined rate, and thereby hedge against the risk of USD exposure.
Leverage: Futures contracts allow investors to create leveraged positions. When the contract is settled on the expiration date, investors can leverage (increase) their positions. For example, a 3:1 leverage allows traders to enter a position three times larger than the value of their trading account.
Short Exposure: Futures contracts allow investors to take short exposure to an asset. When an investor decides to sell a futures contract without owning the underlying asset, it is usually referred to as a 'naked position'.
Asset Diversity: Investors can take exposure to assets that are difficult to trade locally. Commodities such as oil have high shipping and storage costs, but with the use of futures contracts, investors and traders can speculate on a wider range of asset classes without the need to physically trade those assets.
Price Discovery: The futures market is a one-stop shop for sellers and buyers (a place where supply and demand meet) for several asset classes such as commodities. For example, the price of oil can be determined in the futures market in relation to real-time demand on the futures market rather than through local interactions at a gas station. On top of that, futures contracts typically trade during extended trading hours, which allows for more transparency in pricing.
Future Contract Payment Mechanism
The expiration date of a futures contract is the last period of trading activity for that contract. After that, trading stops and the contract is settled. There are two main mechanisms for settling futures contracts:
Physical Payment: The asset underlying a contract is exchanged between two parties agreeing to the contract at a predetermined price. The short party (who sold earlier) holds the bond to deliver the asset to the long party (who bought earlier).
Cash Payment: The assets underlying the contract are not exchanged directly. In return, one party makes a payment to the other party at a rate that reflects the current value of the asset. One example of a cash payment from a futures contract is an oil futures contract, where cash is exchanged rather than barrels of oil, because it would be complicated to trade thousands of physical barrels of oil.
Futures contracts paid for in cash are easier to execute, therefore more popular than contracts paid for in physical goods. Even for more liquid financial securities or fixed income instruments (bonds) whose ownership structure can be transferred relatively quickly (at least when compared to physical assets such as barrels of oil).
However, futures contracts paid in cash can lead to manipulation of the price of the asset underlying the contract. This type of manipulation is usually referred to as "banging the close" - which is a term that describes abnormal trading activity that intentionally disrupts order books (a list of interested buyers and sellers in a financial instrument on an exchange) when a futures contract is nearing its expiration date. .
Exit Strategy for Future Contracts
After taking a futures contract position, there are three main actions a futures trader can take:
Offsetting: Refers to the act of closing a futures contract position by forming an opposing transaction of the same value. So, if a trader acts as a seller of 50 futures contracts, he can open a buyer position of the same value, and ultimately neutralize his position. The offsetting strategy allows traders to realize profits or losses before the payment date.
Rollover: occurs when a trader decides to open a new futures contract position after offsetting (offsetting) the initial contract, essentially the same as extending its expiration date. For example, if a trader is a buyer of 30 futures contracts that will expire in the first week of January, but they want to extend their position for another six months, they can offset the first position and open a new position with the same value and with an expiration date set. being the first week of July.
Settlement: If the futures trader does not perform an offset or rollover action on their position, the contract will settle on the expiration date. At this point, all relevant parties are legally obliged to exchange assets (or cash) according to their respective positions.
Future contract price patterns: contango and normal backwardation
From the time a futures contract is formed until its settlement, the market price of the contract will change constantly in response to buying and selling forces.
The relationship between perfection and varying prices of futures contracts results in different price patterns, which are usually known as contago (1) and normal backwardation (3). This price pattern is directly related to the expected spot price (2) of an asset at the time of the expiry date (4), as illustrated below:
Contango (1): a market situation where the future contract price is higher than the expected spot price.
Expected spot price (2): the price of the asset at the anticipated contract settlement (expiration date). It should be reminded that the expected spot price is not always constant. It can change in response to market supply and demand.
Normal backwardation (3): a market condition where the futures contract price is lower than the expected spot price.
Expiry Date (4): the last day of trading activity of a particular futures contract prior to settlement of the contract.
While contago market conditions tend to favor sellers (short positions) more than buyers (long positions), normal market backwardation usually favors buyers.
As the contract approaches its expiration date, the futures contract is expected to converge to the spot price gradually until they have the same value. If the futures contract and the spot price are not equal on the expiration date, traders will be able to make quick profits from arbitrage opportunities.
In the contago scenario, the futures contract is traded above the expected spot price for convenience reasons. For example, a futures trader may decide to pay more for a physical commodity that will be delivered in the future, so that they do not have to worry about paying costs such as storage fees or insurance (gold is a popular example). In addition, companies can use futures contracts to lock in their future expenditures at predictable values, by purchasing commodities that are essential to their services (e.g. a bread manufacturer purchasing a wheat futures contract).
On the other hand, normal market backwardation occurs when futures contracts trade below the expected spot price. Speculators buy future contracts in the hope of making a profit if the price rises according to expectations. For example, a futures trader may buy oil barrel contracts at $30 per contract today, while the expected spot price is $45 next year.
Closing
As a standard type of forward contract, futures contracts are one of the most widely used tools in the financial industry and their diversity of functions makes them suitable for a wide range of uses in many cases. However, it is still very important to have a good understanding of the underlying mechanisms of futures contracts and markets before investing funds.
While “locking in” the future price of an asset is useful in certain circumstances, it is not always safe – especially when the contract is traded on margin. Therefore, risk management strategies are often used to eliminate the inevitable risks associated with trading futures contracts. Some speculators also use technical analysis indicators in conjunction with fundamental analysis methods as a way to gain insight into prices in the futures market.
